MORGAN STANLEY DEAN WITTER Global Telecommunications Primer Equity Research Global Telecommunications June 1999 A Guide to the Information Superhighway The Global Telecommunications Team 36 MORGAN STANLEY DEAN WITTER This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. Please refer to the notes at the end of this report. Western European Wireline: New Players Change the Landscape Overview The European telecommunications industry is in ferment, as the “triple whammy” of privatisation, liberalisation, and new technology is dramatically reshaping old structures and relationships. Until recently, the traditional incumbent tel- cos — vertically integrated national carriers — have been enjoying a wonderfully benign operating environment, char- acterised by accelerating growth, improved efficiency, often passive regulators and minimal competitive pain — with consequently super-normal returns to shareholders. Pres- sures are mounting on these traditional players, however, as evidenced by the current spate of industry alliances, merg- ers, and takeovers. Increasingly, the industry is being reshaped and rede- fined, not by the telcos, but by a new breed of emerging carriers and service providers. These new players, unen- cumbered by legacy networks, cost structures, or working practices, are profoundly altering the economics of the in- dustry and forcing incumbent telcos to redefine their basic strategies. Until now, the European industry has seen few real failures or corporate disasters, thanks to the saving grace of growth. Winners and losers will undoubtedly emerge, however, as the competitive stakes rise ever higher. Essential character- istics of the “winning strategy” will be inspired leadership, a precise understanding of technology effects, and a resolute focus on the needs of the customer, be it small, medium, or large and retail or wholesale. The business of investing in European telecoms has changed as much as the business itself. In the more chal- lenging and dynamic competitive environment that is emerging, it is clear to us that the old investment rules no longer apply. While “worst is best” used to be a useful guide to investing in telecoms at a time when restructuring and interest rate convergence were the main value drivers, the more efficient and progressive Northern European op- erators and the new breed of alternative carriers have clearly come out on top in terms of value creation since 1/1/98. Our top picks now therefore include the “best in class” and most progressive telcos such as Sonera, KPN, BT, together with new entrants that have what we consider the strongest value-added — such as Equant — or the strongest regional position, such as Mannesmann. Key Investment Themes The European telecommunications industry is experi- encing profound change, stimulated by the simultaneous impact of privatisation, market liberalisation, technology shifts, and, at the continent-wide level, economic and politi- cal convergence. While many of these factors are also af- fecting other regions, the fact that Europe’s past history is one of state intervention, protectionism, and general resis- tance to change — the “open-air museum” as it has been characterised by Byron Wien — means that when change does occur, it is all the more shocking. State ownership of telecoms is coming to an end in Europe . . . Historically, European telecommunications have been organised on a conventional state-owned, verti- cally integrated, monopoly structure, except in Finland. This dirigiste approach has been progressively abandoned by successive European governments, and now virtually all European telcos have been or are subject to a formal plan to be privatised. The U.K., Italian, and Spanish telcos are all effectively in full private ownership; the Swedish and Nor- wegian administrations are committed to begin the privati- sation process within the year; and all other countries have begun the process of reducing state ownership and, with it, state influence. . . . and competition has extended to all telecom sectors across most of the continent. Nearly all European coun- tries began the formal process of introducing competition in the late 1980s. First, the sale of basic telecommunications equipment was liberalised. Then competition was intro- duced in mobile services in the early 1990s, thanks to the development of the pan-European GSM digital cellular standard. Subsequently, value-added services were opened for competition, with various loopholes allowing the simple resale of voice services within closed user groups. Ulti- mately, full market liberalisation was authorised in most countries from 1/1/98, with only Spain, Portugal, and Greece being granted waivers to delay liberalisation. MORGAN STANLEY DEAN WITTER 37 This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. Please refer to the notes at the end of this report. Table 1 Access Lines (Thousands): Western Europe 1993 1994 1995 1996 1997 1998E 1999E 2000E 2001E 2002E 2003E 2004E 2005E 2006E France 30,564 31,400 32,260 33,210 33,941 34,552 34,966 35,316 35,669 36,026 36,386 36,750 37,117 37,488 Growth 2.7% 2.7% 2.9% 2.2% 1.8% 1.2% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% Germany 43,452 43,923 44,393 44,200 45,200 46,104 46,657 47,031 47,407 47,786 48,168 48,554 48,942 49,334 Growth 1.1% 1.1% -0.4% 2.3% 2.0% 1.2% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% 0.8% Italy 24,224 24,398 24,622 25,052 25,553 25,809 26,330 26,865 27,413 28,571 30,139 31,856 33,338 34,934 Growth 0.7% 0.9% 1.7% 2.0% 1.0% 2.0% 2.0% 2.0% 4.2% 5.5% 5.7% 4.7% 4.8% Spain 15,235 15,645 16,055 16,200 16,798 17,249 17,725 18,213 18,752 19,188 19,524 19,762 19,992 20,236 Growth 2.7% 2.6% 0.9% 3.7% 2.7% 2.8% 2.8% 3.0% 2.3% 1.8% 1.2% 1.2% 1.2% Sweden 5,891 5,920 5,950 5,980 6,010 6,040 6,070 6,101 6,131 6,162 6,193 6,224 6,255 6,286 Growth 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% UK 27,336 28,358 29,411 30,677 31,563 32,646 34,012 35,561 36,956 38,143 39,237 40,000 40,779 41,575 Growth 3.7% 3.7% 4.3% 2.9% 3.4% 4.2% 4.6% 3.9% 3.2% 2.9% 1.9% 1.9% 2.0% E = Morgan Stanley Dean Witter Equity Research Estimates Moore’s Law may understate the rate of change in European telecoms. It has been argued that, as the tele- communications industry has been held back by decades of government intervention, cash constraints, and stifling regulation, the process of technological revolution is even more dramatic and shocking than was the case, say, with the dawning of the age of the personal computer. According to this logic, Moore’s Law — that price/performance doubles every 18 months, as suggested by Gordon Moore, founder of Intel — actually understates the speed of future develop- ment in telecommunications. Certainly, evidence abounds that the technology gap that exists between Europe and the U.S. — lower PC penetration, lower IP usage, etc. — may be closing rapidly and that in some areas, notably digital wireless, European telecommunications may already be substantially ahead of the U.S. European economic and political union is driving strate- gic activity. The current move towards economic union across Europe is only the next stage in a process that began with the setting up of the European Coal and Steel Commu- nity back in the 1950s, and continued with, amongst other policy moves, the Europe 1992 initiative. There is no doubt, however, that the emergence of the Euro as a com- mon currency on 1/1/99 has stimulated a new wave of in- dustry consolidation — Vodafone’s acquisition of Airtouch is one such corporate realignment carried out with the Euro- pean, rather than the domestic, consumer in mind. The industry is responding to change with rationalisa- tion, internationalisation, and consolidation. There is not a single telco in Europe that has not put in place a workforce reduction plan. Historically, telcos in Europe have often been regarded by their government owners as employers of last resort, and this has led many to be chronically over- staffed, even by the standards of European industry. In the case of France Telecom, the cost of early retirements was negotiated pre-privatisation and partly borne by the French treasury; in most other cases, these costs have been charged to earnings and borne also by minority shareholders. Either way, cost cutting has been a recurrent theme for some years, with some telcos, such as Deutsche Telekom and Telecom Italia, deriving a large if not dominant part of their recent earnings growth from cost reduction. The impact of organisational and cultural change on the competitiveness of the European telcos is less evident. British Telecom took years, and a number of false starts, following its own 1984 privatisation, before it was able to put in place a meaningful internal restructuring and improve responsiveness and customer orientation. Relatively few operators — only France Telecom, KPN of the Netherlands, Telia of Sweden, and Sonera of Finland — have been able to boast any sort of customer-oriented culture being in place for some years. Still others, notably Deutsche Telekom, are only now putting in place the necessary management and organisational changes, while unreconstructed monopolists, such as Telecom Italia, have barely begun the process. Competitive pressures have made internationalisation essential for European operators. There have been three clear reasons for the telcos’ drive to internationalise their businesses. First, faced with prospect of a certain loss of domestic market share, and with balance sheets fortified by years of monopoly-protected, efficiency-derived cash flow, the majority of European telcos have sought to diversify their earnings base by making overseas investments and 38 MORGAN STANLEY DEAN WITTER This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. Please refer to the notes at the end of this report. Table 2 Wireline Penetration: Western Europe 1993 1994 1995 1996 1997 1998E 1999E 2000E 2001E 2002E 2003E 2004E 2005E 2006E France 52.2% 53.6% 55.1% 56.4% 57.5% 58.4% 59.3% 60.0% 60.6% 61.2% 61.8% 62.4% 63.0% 63.7% Growth 2.7% 2.7% 2.5% 1.9% 1.6% 1.5% 1.1% NA NA NA NA NA NA Germany 52.9% 53.5% 54.1% 53.8% 55.1% 56.2% 56.8% 57.3% 57.7% 58.2% 58.7% 59.1% 59.6% 60.1% Growth 1.1% 1.1% -0.4% 2.3% 2.0% 1.2% 0.8% NA NA NA NA NA NA Italy 42.6% 43.0% 43.3% 44.5% 45.0% 45.4% 45.9% 46.4% 46.8% 47.3% 47.8% 48.2% 48.9% 49.4% Growth 0.7% 0.9% 2.8% 1.0% 1.0% 1.0% 1.0% NA NA NA NA NA NA Spain 39.0% 40.0% 41.1% 41.4% 43.0% 44.1% 45.3% 46.6% 48.0% 49.1% 49.9% 50.5% 51.1% 51.8% Growth 2.7% 2.6% 0.9% 3.7% 2.7% 2.8% 2.8% NA NA NA NA NA NA Sweden 66.2% 66.5% 66.9% 67.2% 67.5% 67.9% 68.2% 68.5% 68.9% 69.2% 69.6% 69.9% 70.3% 70.6% Growth 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% NA NA NA NA NA NA UK 47.9% 49.5% 51.1% 53.0% 54.2% 55.8% 57.8% 60.2% 62.2% 63.9% 65.4% 66.3% 67.3% 68.3% Growth 3.4% 3.2% 3.8% 2.4% 2.9% 3.7% 4.0% NA NA NA NA NA NA E = Morgan Stanley Dean Witter Equity Research Estimates acquisitions — some very successfully as with Telefónica in Latin America, some much less so, as with Deutsche Tele- kom. Second, telcos have sought to protect their multina- tional client business by following their customers into in- ternational markets. The old model achieved this through operator alliances such as Unisource (between KPN, Swiss- com, and Telia and, for a while, AT&T) or Global One (between France Telecom, Deutsche Telekom, and Sprint), but these have generally proven to be unstable and unable to deliver meaningful returns to their owners — or even to their customers. The new international model allows the telco to invest more selectively and to retain greater control — such as KPN’s 50/50 joint-venture with Qwest of the U.S., to build out a pan-European, IP-based fibre network, or Swisscom’s “hot spot” strategy of establishing points of presence in major traffic hubs across Europe and the U.S., in order to collect and deliver international traffic at locally determined interconnect rates rather than at exorbitantly high interna- tional accounting rates. BT seems to be migrating its earlier model of selective minority investments in alternate carriers across Europe — Cegetel in France, Viag Interkom in Ger- many, Albacom in Italy — to one that allows greater control by BT in an overlay IP-based network. Competitive pressures combined with the prospect of a single Eurozone have stimulated a significant increase in consolidation across Europe. Some of this activity is driven by relatively straightforward scale considerations — for example, the planned merger between Telia of Sweden and Telenor of Norway, where two relatively small opera- tors, sharing similar organisational and national cultures, would seem to have a high probability of achieving the benefits that consolidation promises. Some consolidation, however, appears to be driven more by old-style considera- tions of size for size’s sake, where the sheer scale of the entities and the clear cultural dissimilarities suggest a high probability of failure. The business of investing in European telecoms has changed as much as the business itself. In the more chal- lenging and dynamic competitive environment that is emerging, it is clear to us that the old investment rules no longer apply. While “worst is best” used to be a useful guide to investing in telecoms at a time when restructuring and interest rate convergence were the main value drivers — Southern European operators outperformed Northern Euro- pean operators by 148% during 1996 and 1997 — the more efficient and progressive Northern European operators and the new breed of alternative carriers have clearly come out on top in terms of value creation since 1/1/98. Our top picks now therefore include the “best in class” and most progressive telcos such as Sonera (which we be- lieve can be viewed either as an expensive telco or, more usefully, a very inexpensive cellular/data company); KPN, one of the best values of the more advanced operators; BT, finally emerging from years of competition- and regulation- induced revenue constraint; together with those new entrants that have what we consider the strongest value-added — such as Equant — or the strongest regional position, such as Mannesmann. Market Growth If the response of individual telcos to the triple challenge of privatisation, liberalisation, and new technology has varied, MORGAN STANLEY DEAN WITTER 39 This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. Please refer to the notes at the end of this report. the response of the marketplace to this new industry dyna- mism has been very consistent — an across-the-board ac- celeration in growth rates. The reasons for the structural uplift in growth rates are not hard to see. First, digitisation has brought higher functionality to the basic, traditional, voice telephone: higher-speed access through ISDN, plus network-based services such as caller ID, call diversion, voice mail, freephone, mobile, and many other service variants are all becoming ubiquitous, stimula- tive, and chargeable add-ons to the basic telephone package. Second, more attractive (i.e., lower) prices and price plans have become available, with an increased focus on market segmentation yielding rich rewards to operators in the form of previously undreamt-of penetration levels. The pre-paid concept has been particularly successful in im- proving the affordability of basic cellular service, opening the possibility of a genuinely mass-market service. Third, more intensive advertising by operators eager to establish their market presence has resulted in higher con- sumer awareness of telecommunications per se, and higher usage levels. Fourth, the “old world” of plain old telephone service is rapidly evolving into a brave new world of converged, multimedia, content-rich services, where — to quote the current mythology — “the Internet changes everything,” including, it seems, the capacity of individuals and corpora- tions to spend money on telecommunications services. Against this generally very supportive demand picture, what has been happening in individual markets? In Germany, overall market growth was constrained in 1998/1999 by rapid price reductions in long distance (domestic and international). However, strong volume growth from an explosion of competitive activity and from sustained growth in ISDN lines and on-line services oc- curred. A similar pattern of price decline and volume growth was also present in the German mobile market. In France, overall market growth was constrained in 1998 by the final effects of a deliberate policy by France Telecom of reducing the level of domestic long distance (DLD) and international long distance (ILD) prices. This policy began in 1996 as a means to head off the com- petitive/arbitrage threat. As in Germany, line growth driven by second lines to the home and online services increased demand. Price reductions, combined with more effective marketing and new service promotion by France Telecom (FT), have produced a significant pickup in volume growth (in both the fixed and mobile markets). Again like Ger- many, sophisticated but under-penetrated/under-exploited business and residential customer bases suggest a strong potential for high take-up of broadband services. The Italian fixed line market experienced only modest growth in 1998. This occurred for several reasons: the im- pact of DLD/ILD price reductions; failure by Telecom Italia to develop and promote new network-based services; low penetration of PCs; low sophistication of corporate users; and significant migration of fixed line traffic to the mobile networks. From this low base, we anticipate acceleration in market growth rates, as the entry of new competitors stimu- lates higher usage rates. The Spanish fixed line market has experienced ex- tremely strong acceleration in growth over the last two years. This growth has been fueled by a very strong do- mestic economy; a highly effective rollout of new services (network-based voice mail, for example) and the rapid take- up of on-line services (TEF’s Infovia dominates the market). Growth rates should remain strong as new entrants stimulate higher consumer awareness. Lastly, Spain is the only major country in Europe whose lines per capita are significantly below the Western European average. Regulatory and Competitive Environments As noted, virtually all European markets opened formally to full competition on 1/1/98, after a lengthy period of pan- European policy coordination and following the general dictates of a series of European Directives. However, while there has been considerable coordination of policymaking by Brussels and the European Commission, this does not mean that countries are approaching the busi- ness of implementing liberalisation uniformly. Indeed, while it is Brussels’ role to set an overall policy framework for telecommunications liberalisation, it remains a matter for national regulators to enact these objectives in specific 40 MORGAN STANLEY DEAN WITTER This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. Please refer to the notes at the end of this report. national legislation, and to give practical effect to these Di- rectives in day-to-day decision making. We see a wide range of regulatory environments across Europe, from the strongly pro-competitive regime that has prevailed in the U.K., Germany, and the Netherlands, to the more subtly pro-incumbent stance adopted by the French regulatory authorities, right the way through to the regula- tory vacuum that is only now beginning to be filled in Italy. Simply to judge by the number of companies operating in each country, it is easy to see the role that national regula- tors still have — even in this ostensibly “liberalised” world — in shaping the structure of the industry. It is therefore important for the investors to understand that regulators retain significant power to affect the economics of individ- ual market segments as well as investor sentiment. Con- sider KPN’s travails in the Dutch market, against a regulator determined, it seems, to deliver a consumer- and competi- tor-friendly package. The German government is a very pro-competitive regulator. Consequently, Germany has experienced an explosion of competitive activity. This “bulge bucket” in- cludes Mannesmann Arcor, using the Deutsche Bahn rail- way network; O tel O, using the electricity infrastructure of RWE and Veba, the principal owners; and Interkom, the BT/Viag joint venture, pioneering the use of a combined fixed/mobile network. However, headlines and market share in Germany have been grabbed by the resellers — Mobilcom, TelDaFax, Talkline, ACC, etc. — which have been more aggressive and innova- tive in pricing (Mobilcom’s 01019 access code reflects its 19 pfennig standard call rate, initially some 60% below DT’s DLD rate). There are many competitive models in Europe’s most competitive market. Several of those em- ployed are facilities-based, switched-based and switchless resellers, CLECs (MFS, COLT, and many city networks), plus unbundled local loop (ULL), wireless local loop (WLL), and cable telephony. The German market has been characterized by the rapid emergence of a complete range of competitive models. An extremely high current rate of new company formation should eventually give way to a period of con- solidation as 1) scale seeks volume, 2) reach seeks access, and 3) bandwidth seeks content. The French case is very different from the German. France Telecom has a history of high-quality basic service (government underwritten!). For this reason, in particular, there is a high degree of customer satisfaction and a low propensity to switch to alternate providers. The French regulator, the ART, also tends to be very France Telcom- friendly. Interconnect rates are essentially two-tiered, with only large, facilities-based competitors qualifying for the lower rates. In France, there is only one major competitor for fixed services — Cegetel, owned by Vivendi (the utility), BT, and Mannesmann. There are a few resellers — Omnicom, Es- prit among them, and even these have been acquired by a larger, facilities-based company. Cable TV is not very highly penetrated in France, and a large part of it is owned or operated by FT. Although FT (and its investors) believe FT enjoys the closest thing in Europe to a “natural monop- oly,” competitive pressures should intensify — witness COLT’s success in the Paris region. Competition has been slow to develop in Italy for many “non-tariff barrier” reasons. Historically, the regulatory infrastructure has been almost totally absent, so licenses have taken months or longer to be issued, and physical con- Figure 1 The German Case Study Cellular Service Providers Internet Service Providers CLECs: COLT MFS ISIS Net Cologne etc Facilities Based: DTAG Arcor/D2 o.tel.o Interkom WorldCom Resellers: ACC Mobilcom TelePassport Viatel Esprit ThyssenTelecom TelDaFax Light Local National Source: Morgan Stanley Dean Witter Equity Research Estimates MORGAN STANLEY DEAN WITTER 41 This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. Please refer to the notes at the end of this report. nection with Telecom Italia’s network has been delayed. The landscape is changing, however. The new regulator has at last been established, if not completely staffed up yet, and new entrants are having a relatively easy go at Telecom Italia’s more vulnerable customers. With high DLD/ILD prices (historically and even now), an inflexible organization, and 18 months of management dis- traction/hiatus, we believe Telecom Italia is certainly vul- nerable — but the new management should force changes. In the meantime, major players include Infostrada (now wholly owned by Mannesmann), COLT, Albacom (owned by BT), and Wind (the FT/DT joint venture, using the third cellular license as an entry vehicle to the fixed market). Competition was also late in coming to Spain, although by design rather than by default (as in Italy). Reflecting its less developed status, Telefónica won a concession from the Brussels authorities to face only limited competition starting on January 1, 1998. Competition came in the form of Retevisión, which is co-owned by Endesa (the utility) and Telecom Italia. Since December 1, 1998, however, the market has been open to all comers, and at least nine op- erators have been licensed to provide competitive LD serv- ices. Cable telephony is also emerging as a competitive threat to Telefónica. This is particularly true as multiple licenses have been awarded across a largely unpenetrated country. Competition in the German DLD/ILD markets could be reduced. Huge (60%) reductions in Deutsche Telekom pricing could have the effect of choking off competition in DLD/ILD. We think this will not be the case, because DT has such a heavy cost burden to carry (labour, capital, debt, and dividends) that its pricing flexibility is far more limited than for most operators. In France, we believe the Internet has significant poten- tial. However, whether the French market will be as willing to adopt the Internet as is assumed, given cultural issues and FT’s late conversion, will be an important factor in whether the French market experiences the data growth of other markets, in our opinion. Competing digital TV platforms are an important devel- opment to watch in the Spanish telecom market. Tele- fónica and Canal +’s competing digital TV platforms will go head-to-head in this marketplace. A related, but distinct, issue is the vulnerability of TEF’s corporate business. His- torically, TEF has had a highly effective stranglehold on this business, but that seems to be weakening. 42 MORGAN STANLEY DEAN WITTER This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. Please refer to the notes at the end of this report. Western European Wireless: Fixed-Mobile Convergence Looms Overview We continue to see strong growth ahead in European cellular markets . . . Despite record growth in Scandina- via last year, penetration continues to rise. We believe that with expanded distribution, 60%-plus penetration in Scan- dinavia is achievable within three years. Germany is under- penetrated at 18%. Fundamentals appear strong for the two incumbents in Italy, where penetration is highest. Moreo- ver, rising usage is offsetting price declines, putting paid to the conventional wisdom concerning the elasticity of de- mand. And new technologies are increasing transmission speeds, making wireless data transfer commercially viable. . . . Despite the risk of increasing regulation. Although the limited amount of spectrum appears to put natural con- straints on competition, concerns are increasing that regu- lators will force cellular operators to provide competitive access to their networks under a cost-based interconnect system, with Norway as a precedent. While the situation bears watching, we see little evidence of supernormal profits that would warrant intervention by the regulators over the near term, particularly with prices falling throughout Europe. In addition, opening the networks could create congestion and reduce the quality of service. That said, operating licenses will increasingly shape the wireless mar- ket in western Europe, with universal mobile telephony li- censes potentially affecting operator capacity and expanding the range of service offerings. The convergence of fixed and mobile communications presents threats and opportunities. Cellular operators will have to cut prices while investing in infrastructure to improve network coverage and quality, but face a huge op- portunity and can use excess capacity on their networks. Public telephony operators need to integrate their cellular subsidiaries to protect their core markets, while exploiting their advantage in delivering broadband services over fixed lines. Our favorites in this evolving competitive landscape are Mannesmann and Securicor. Investment Themes and Market Growth The past year has seen very good growth in European cellular markets but there is more to come, in our view. A year ago, the Scandinavian wireless market was generally thought to be approaching post-growth status, with its penetration leading the rest of the world at 37.7%, but the consensus was far off the mark. One year later, after record growth, penetration in Scandinavia is 53.6% and rising. A closer look at the age and gender profile of users in Norway provides further encouragement. Among 20- to 29-year-old men, nearly 100% currently have cellular phones, compared with only one-third of women in that age group. In our view, expanded distribution can only help to address the market’s underpenetrated segments (young fe- male and elderly), making 60%-plus penetration in Scandi- navia within three years an achievable target. Figure 1 Year-End Penetration at 1 March 1999 (%) 0.0 10.0 20.0 30.0 40.0 50.0 60.0 70.0 Germany Spain Greece UK Ireland Luxembourg Denmark Norway Finland Source: Mobile Communications, Morgan Stanley Dean Witter Research Figure 2 Penetration by Age Group 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 0-19 20-29 30-39 40-49 50-59 60-69 70-79 80+ Total Current Penetration Source: NetCom ASA, Morgan Stanley Dean Witter Research MORGAN STANLEY DEAN WITTER 43 This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. Please refer to the notes at the end of this report. Despite marked reductions in cellular pricing (by as much as 30% in the U.K. and Germany), ARPU has typically remained robust. Clearly, the consensus view of elasticity trends is being challenged. The old outlook, based on the experience of Vodafone and Mannesmann in 1996, was that a 10% reduction in pricing typically was accompa- nied by a 6% increase in usage, so that net ARPU fell by an average of 4%. It appears that this relationship no longer holds, as price declines are being offset by rising usage, with no difference between usage levels during peak and off-peak periods. The data wave has yet to be experienced in cellular mar- kets. We believe that cellular is not the only growth game in telecom. The European data market (which we forecast will be worth around $30 billion in 2002) is currently about the same size as the European cellular market. In the past, we have been very sceptical about the transfer of data over GSM, given the structural hurdles, including a lack of mo- dem standardisation, prohibitive terminal costs, lack of dedicated applications combined with very slow data trans- mission speeds (at fax speeds of 9.6 kb per second). How- ever, with the advent of new technologies such as high- speed circuit-switched data (HSCSD) and general packet radio services (GPRS), quantum leaps in transmission speeds of up to 64kb/s are likely. The development of SMS (short message service) in Scandinavia has led us to believe that data will play a very significant role over cellular net- works. All of this potential growth has yet to be factored into forecasts, both operational and funding requirements, although early indications from European operators are that the investment required is moderate. We believe the data component of cellular will provide the main impetus for the next wave of cellular re-rating over the next year. The conventional view on ARPU decline is already being challenged by the most basic of data services. We believe the take-up of SMS messaging in Finland (and elsewhere) is testament to the latent demand that exists for easily accessi- ble data over mobile. Whilst the service involves multiple key entries, in Scandinavia, SMS accounts for 7% of cellu- lar revenues. Improving data speed should provide the technical catalyst to further growth. Current data speeds of 9.6kb/s should climb to 14.4kb/s by 3Q of this year with Sonera planning to launch HSCSD. This technology can be ex- panded through the use of multi-slot techniques to achieve data speeds at ISDN-equivalent levels. Within the next 12 months, with four time slots HSCSD can support data speeds of up to 57kb/s. While HSCSD reflects only an in- terim measure, given its circuit-based switching, inefficient use of spectrum, and lack of price flexibility, it nevertheless provides operators the chance to satisfy early adopters and promote more advanced data services prior to launch at an immaterial incremental cost — Sonera’s network will be able to offer the service when terminal handsets become available in the third quarter of 1999. Figure 3 Cellular: Improving Data Capabilities 0 0,25 0,5 0,75 1 GSM Ph1 PSTN ISDN GSM 2+ UMTS video clip photo report video clip photo reportwebe-mail video clip photo reportwebe-mail video clip photo reportwebe-mail video clip web photo report 10 sec 1 min 10 min 1 hour Transmission Time Source: UMTS Forum Figure 4 European Cellular: Penetration Outlook 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0% 90.0% 1998 1999E 2000E 2001E 2002E 2003E Finland France Germany Italy Norway Spain Sweden UK E = Morgan Stanley Dean Witter Research Estimates Source: Company data, Morgan Stanley Dean Witter Research 44 MORGAN STANLEY DEAN WITTER This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned. Please refer to the notes at the end of this report. Table 1 European Cellular: Churn, 1998-2002E (%) 1998 1999E 2000E 2001E 2002E Cellnet 28.8 25.9 24.5 23.3 22.1 D2 Mobilfunk 19.0 20.0 20.0 20.0 20.0 Europolitan 19.7 19.4 18.8 18.5 18.3 NetCom GSM 26.8 22.6 20.3 20.0 19.8 Orange 21.7 22.9 21.6 20.5 19.4 SFR 23.7 23.2 22.9 22.7 21.6 European Mean 22.6 22.1 21.6 20.9 20.1 European Median 21.7 22.6 20.3 20.0 19.8 E = Morgan Stanley Dean Witter Research Estimates Source: Company data, Morgan Stanley Dean Witter Research HSCSD provides some progress, but we believe the real breakthrough will be the rollout of general packet radio services (GPRS). GPRS will enable cellular operators to be more Internet Protocol (IP) transparent, providing seamless transfer into Internet networks. Data speeds of up to 120kb/s are achievable, with packet switching resulting in a more efficient use of capacity. Sonera aims to launch this service next year. The final incremental development is the deployment of EDGE (Enhanced Data rates over GSM Evolution), which uses alternative modulation schemes, resulting in higher data speeds of around 200kb/s, although Nokia believes data speeds beyond 300kb/s should be achievable, making EDGE comparable with the early third-generation offerings. EDGE is likely to be implemented in 2000/01, at least one year prior to the commercial launch of universal mobile telephony licenses (UMTS). UMTS will allow 384kb/s in wide area usage and up to 2mb/s is available to stationary users. UMTS presents operators with additional spectrum, and at least the ability to support the rapid migration of voice traffic onto cellular networks. The key concern, in our view, is that investors may not see the benefits of future growth and penalise companies for short-term earnings dilution. We believe those that benefited from first mover advantage at the cellular level and therefore dominate the corporate market will be less exposed to investor scepticism, as after all, it is the corpora- tions who will likely be the early adopters of these services. Once scale economies, the availability of affordable hand- sets, and coverage and capacity investment allow for wide- spread consumer take-up, the visibility of the strong growth prospects should improve. In addition, we take comfort from the following; • Cellular growth has not disappointed — our analysis in- dicates the re-rating of cellular stocks over the last two years almost wholly reflects estimates significantly exceeding all expectations. • The successful take-up of SMS — accounting for 7% of ARPU in 1Q99 in Scandinavia — indicates a high accep- tance for data services. • The rollout of HSCSD and GPRS solutions should also provide a further guide toward incremental returns from higher capital expenditure. Concerns about regulatory risk in the European wireless market are rising. Although we have seen a rapid lower- ing of entry barriers in the fixed line market, the same is not true of the mobile market. In fact, the current conventional Figure 5 European Cellular Performance 12/3/99 MAMJ JASOND JFMAMJ JASOND JFM 100 150 200 250 300 350 400 450 EU CELLULAR - PRICE INDEX MSCI EUROPE 15 U$ - PRICE INDEX EUROPE-DS TELECOMMS. - PRICE INDEX Source: DATASTREAM [...]... -1.3% $30.8 -1.3% Hong Kong Growth NA $130.3 NA $118.8 NA $111.0 NA $75.0 NA $58.7 NA $44.1 NA $40.6 -7.9% $38.1 -6.1% $36.4 -4.6% $34.8 -4.5% $33.2 -4.4% $31.8 -4.3% $31.5 -1.0% India Growth NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA Indonesia Growth NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA Korea Growth $59.2 $66.0 11.5% $69.8... 73.6% 1.0% India** Growth NA NA NA NA NA NA NA 0.1% NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA Indonesia Growth NA NA NA NA NA 0.3% NA 0.5% 60.1% 0.4% -18.2% NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA Korea Growth 1.1% 2.2% 101.7% 3.7% 70.3% 7.0% 90.4% 14.9% 112.0% 30.0% 102.0% 36.1% 20.4% 40.7% 12.5% 43.7% 7.6% 45.8% 4.6% 47.4% 3.6% 49.1% 3.6% 50.9% 3.6% 52.8% 3.6% Malaysia Growth 1.8%... Australia Indonesia Malaysia Philippines Thailand India Australia Sources: Company data and Morgan Stanley Dean Witter Equity Research Sources: Company data and Morgan Stanley Dean Witter Equity Research competition Our Asian cellular favorites all possess strong balance sheets and brand names and — in the case of SmarTone and AIS — strategic ownership by large foreign partners (British Telecom and Singapore... likely surface in Thailand, Indonesia, and India However, we expect new operators to enter gradually in Australia, China, Singapore, and New Zealand Digital conversion risk remains high for a number of carriers Incumbent carriers in Thailand, Malaysia, the Philippines, Australia, and New Zealand maintain high proportions of their customers on analog networks This poses a problem, we believe, as analog networks... as they strive to migrate analog users onto their own digital platforms This has been the case for SK Telecom in Korea, which has migrated from 100% analog to nearly 90% digital within the last four years MORGAN STANLEY DEAN WITTER Singapore 64 ** CHTK operating provinces only Sources: Company data and Morgan Stanley Dean Witter Equity Research This memorandum is based on information available to the. .. long distance revenues is increasing, however U.S courts have approved the Federal Communications Commission’s (FCC) pricing and timing benchmarks, causing settlement rates to drop quickly across Asia As a result, Asia’s operators are appealing to local regulators for tariff rebalancing (generally raising local monthly rates and decreasing international rates) to make up for falling international revenues... networks in Asia suggest that the former standard will remain dominant over the near term Ultimately, however, greater data demand should push users toward the higher bandwidth expected from W-CDMA Availability of Calling-Party-Pays China** Mobile data services should increase subscriber utilization and revenue generation Operators are offering new data services to maintain ARPUs in the face of competition... No No Asia China Hong Kong India Indonesia Korea Malaysia The Philippines Singapore Taiwan Thailand Source: Morgan Stanley Dean Witter Research This memorandum is based on information available to the public No representation is made that it is accurate or complete This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities mentioned Please refer to the. .. Finland Japan New Zealand Main lines per 100 people Taiwan 40.0 Israel Portugal Cellular as Supplement 30.0 Cellular as Substitute 20.0 Hungary Malaysia Venezuela Lebanon 10.0 Brazil Thailand Philippines Sri Lanka China Gabon 0 Source: ITU 5 Indonesia Laos 10 15 20 25 Cellular subscribers as % of total subscribers This memorandum is based on information available to the public No representation is made... increasing Asian operators are particularly vulnerable, as global op- Competitors have greater success taking international and domestic long distance market share, but falling tariffs threaten to undermine these revenues Nonetheless, local competition is set to begin soon in Korea and Singapore Consolidation will likely follow in the wake of the financial crisis Competitors’ business plans have fallen apart . $57.0 Growth NA -1 1.0% -1 0.6% -9 .1% -7 .9% Germany $92.6 $75.6 $61.6 $55.9 $52.6 Growth NA -1 8.3% -1 8.5% -9 .4% -5 .8% Italy $67.1 $50.5 $45.8 $44.0 $42.8 Growth NA -2 4.8% -9 .3% -3 .9% -2 .8% Spain. Growth NA -1 0.6% -9 .4% -6 .7% -5 .4% Sweden $68.6 $68.1 $60.1 $56.4 $55.1 Growth NA NA NA -6 .2% -2 .3% UK $64.9 $62.8 $56.6 $47.4 $43.3 Growth NA -3 .3% -9 .8% -1 6.4% -8 .6% E = Morgan Stanley Dean. MORGAN STANLEY DEAN WITTER Global Telecommunications Primer Equity Research Global Telecommunications June 1999 A Guide to the Information Superhighway The Global Telecommunications Team 36 MORGAN